“Putting the nation’s mutual-fund industry under even more intense scrutiny, the Securities and Exchange Commission is deepening its investigation into arrangements between fund companies and brokerage houses and whether those agreements improperly influence which funds brokers recommend to investors,” writes Tom Lauricalla in today’s Wall Street Journal.

“The investigation, which for months has been looking into fund-industry sales practices, is now examining whether some mutual-fund companies agreed to direct orders for stock-and-bond trading to brokerage houses that in turn agreed to promote sales of the fund company’s products, according to people familiar with the probe.”

“More than 15 brokerage firms are being examined as part of the investigation, these people said. It wasn’t clear how many fund companies are included in the SEC probe. Morgan Stanley, a big Wall Street brokerage firm, said in a routine filing with government regulators last week that the SEC was considering bringing charges against it, partly on the ground that it allegedly favored certain fund companies based on brokerage commissions ‘received or expected’ from them. A spokeswoman for Morgan Stanley said it is cooperating with the SEC.”

“The broadened investigation could turn out to be another severe headache for the mutual-fund industry, a prime investment vehicle for half of all American households. Some 95 million U.S. investors hold assets in mutual funds valued at $7 trillion.”

“After decades of operating relatively scandal-free, the industry has been rattled by almost daily revelations or allegations of wrongdoing related to how shares of the funds are traded. Separate investigations into these practices are being conducted by the SEC and New York Attorney General Eliot Spitzer. These probes seek to determine whether some big investors were allowed to buy and sell fund shares on favorable terms not available to other investors, who suffered financially as a result.”

“In the latest investigation, the SEC is looking at whether investors were misled by brokers who sold them funds because of lucrative arrangements their firms had with mutual-fund companies. The inquiry also is looking at whether mutual-fund companies overpaid in commissions in return for brokerage firms agreeing to promote their funds.”

“The latest SEC investigation ‘is one more example of what the trading scandal has revealed, which is that increasingly everything in the fund industry is favoring the manager at the expense of the shareholder, who is losing out because the fund may be paying too much in commissions,’ says Jack Bogle, founder of Vanguard Group, one of the country’s biggest mutual-fund companies.”

“The SEC could eventually bring enforcement action against brokerage firms for failing to disclose that they favored certain funds based on commissions they earn from stock-and-bond trading done by those fund companies, according to people familiar with the investigation. Such agreements also could violate SEC rules governing how fund companies are supposed to decide where to allocate their trading-commission dollars. In addition, brokerage firms could be in violation of rules set by the National Association of Securities Dealers that prohibit recommending funds to clients based on commissions received from fund companies. Brokers are supposed to base their advice on which investments are most appropriate for an investor. The NASD regulates brokers’ sales practices.”

“While SEC officials have repeatedly said publicly that the agency was looking into sales agreements between mutual funds and brokers, the revelation of deals hinging on commissions represents a new twist to the probe.”